When Can I Expect The Value Of My Preference Shares To Rise?

Question:

I have always considered preference shares had two attributes compared to ordinary shares in that they have more assured dividends and should be less volatile.

ASB, Origin Energy and RaboBank have all issued preference shares in the past two years that have dividend annual reset rates based on one-year swap rates. This, I recognised, would limit the prospect of capital gain, but I assumed that the capital value of the shares would stay close to par. Not so. The capital values presently are: ASB, 72 per cent, Origin Energy, 63 per cent and Rabo, 82 per cent of par value.

Can you advise what the market conditions would be whereby I could expect their values to move closer to par?

The obvious answer is "when swap rates rise". However, I have a nasty
feeling that general rates will also rise and the capital value of these
preference shares is likely to remain heavily discounted. Is there hope
or have I been conned?

Answer:

Mary Holm: There's hope, but don't hold your breath. As to whether you've been
conned, that depends on what you were told when you bought the
preference shares.

To put others in the picture, preference shares generally fall between
bonds and ordinary shares in risk and volatility, so the returns should
also be in between. They are usually perpetual - meaning they have no
maturity date. To get your money back, you need to sell the shares.

If the company gets into trouble, preference shareholders stand in line
after bondholders but before ordinary shareholders.

Traditionally, preference shares paid a fixed dividend. But recently
issuers have tended to regularly reset the dividend rates, as you
describe.

"A few years ago, some companies issued them when there was a shortage
of bonds, and so the margin they offered was low given the risk," says
Michael Chamberlain of SuperLife.

Since then, interest rates have risen, so the value of the preference
shares has fallen, pushing up their future expected returns to reflect
their risk. "For them to move back to par, the markets would again have
to be tight," says Chamberlain.

He concludes that you probably paid too much for the preference shares.
If he's correct, it will take another shortage of better alternatives
for their value to rise to par - their original issue price. It could be
a long wait.

Even if the preference shares had been priced better, Chamberlain
doesn't like them. "No investor should buy perpetual bonds or preference
shares. The only way to get your money back is to sell them," and
therefore pay transaction costs. You also run the risk the market price
will be below par, as it is now. By comparison, if you hold ordinary
bonds you get your money back at maturity and pay no brokerage.